Don't count on finessing fiscal problem
03/05/18 Filed in: Spending
Reader feedback at end.
SAFE keeps warning about the perils of chronic government deficits and rising debt, yet the day of reckoning (a fiscal meltdown) never seems to arrive. And there's a school of thought that such a result may be avoidable, because this country can grow its way out of the problem. Trump's economic gamble might actually make sense, Connor Sen, bloomberg.com, 2/27/18.
•The idea is that by running the economy hot and making labor more expensive, the government can induce businesses to do more investment than they would in a normal economy. Ever since the financial crisis, a weak economy has discouraged businesses from investing, leading to weaker productivity growth -- so why not try the opposite?
•The deficit experiment has two possible outcomes. In the best case, the U.S. gets some form of productivity miracle. In the other, rising inflation forces the Fed to raise interest rates to cool off the economy, triggering a recession.
•Republicans and Democrats may disagree on the best way to create deficits, whether it be tax cuts and military spending or investments in infrastructure and education. But the balance of risks leans toward trying this experiment. Be it the Trump administration or the next, someone was eventually going to take the gamble.
Does this line of reasoning hold water, or is it just another rationale for doing what politicians instinctively yearn to do - spend money on their favorite government programs without the need to raise taxes? Based on the following discussion, the latter seems closer to the mark.
A. We agree to a point - US economic growth in recent years has fallen below the historical average. It would be great to raise the annual growth rate by say one percentage point (e.g., from 2% to 3%) or more. Not only would this contribute to the prosperity of Americans, but it would also increase tax revenue for the government over time without raising tax rates - a win/win outcome. A peaceful, easy and just prescription for growth, Veronique de Rugy, townhall.com, 3/1/18.
It's reasonable to assume that economic growth can be accelerated by streamlining government regulations (as the new administration has been doing, with a few exceptions) and cutting taxes (a big tax cut was enacted in December). Why? Money that would otherwise be channeled into nonproductive business expenses or consumption will be shifted to savings/investment.
Streamlining regulations shouldn't add to the government's deficits, even in the short run, so the only real issue is ensuring that the regulatory changes won't have harmful results. Others may disagree, but thus far we're not worried on that score. Regulatory rollback, 7/31/17 (energy) & 8/7/17 (other).
Tax cuts reduce projected tax revenue (thereby increasing deficits), but this effect can be mitigated by a higher economic growth rate. The recent tax cut will reduce government revenue by about $1 trillion over the next 10 years. This net revenue loss could have been reduced by terminating more corporate tax preferences like the Wind Production Tax Credit (or the case of individuals not increasing the Child Tax Credit), but one can't reasonably expect perfection in legislation. Assessing Republican tax plan, 11/13/17.
US economic growth has ticked up under the current administration, and it was recently reported that the 3% target might be hit this year. US economic growth slows in fourth-quarter, cnbc.com, 1/26/18.
The economy grew 2.3 percent in 2017, an acceleration from the 1.5 percent logged in 2016. Economists expect annual GDP growth will hit the government's 3 percent target this year, spurred in part by a weak dollar, rising oil prices and strengthening global economy.
Flirtation with protectionist trade policies could backfire, however, undoing the progress that has been made in other areas. First it was washing machines and solar panels, now comes imported metals (which drew a sharp reaction from many observers), and who knows what the results will be if the president follows through on threats to pull this country out of the North American Free Trade Agreement. Trump to slap tariffs on steel [25%], aluminum [10%], S. A. Miller & Dave Boyer, Washington Times, 3/1/18.
Republicans slamming the tariffs included Senate Finance Committee Chairman Orrin G. Hatch of Utah, Sen. Patrick J. Toomey from steel-dominant Pennsylvania and staunch conservative Sen. Mike Lee of Utah. Joshua Bolten, president of the Business Roundtable, said the group "strongly disagrees" with the president on this score. *** Larry Kudlow, the economic analyst and conservative commentator who helped Mr. Trump craft his tax cut plan, tweeted his disappointment also. "Tariffs are taxes on users, think cars, trucks, planes, cans etc. POTUS so good on taxes & regs, so bad on trade," he wrote.
B. A bridge too far - It's one thing to conclude that the GOP tax cut may be justifiable - despite immediate deficit increases - as a means to jumpstart economic growth. Saying this about all government deficits, whatever the cause, is another matter.
True, some economists (e.g., Lord Maynard Keynes) have advocated boosting government spending during economic downturns in order to make up for the purported insufficiency of private sector demand. And they aren't inclined to be overly concerned about the specific merits of the spending so long as it will arguably keep the economy humming. Where Keynes went wrong, Hunter Lewis, 2009.
Economic crises and recessions serve no useful purpose - misdirected investment is better than no investment at all - prompt and decisive government intervention is indicated at the first signs of trouble - the central bank should not only act as the "lender of last resort" (Walter Bagehot, 1873), but ensure low interest rates for all borrowers - government deficits during a slump will have a greater effect on overall output due to a multiplier effect as high as "three or four times" - markets won't self-correct if the government fails to act - wage levels should not be driven down to promote full employment as that wouldn't be fair - falling prices (deflation) should be assiduously avoided - inflation only becomes a problem if essentially all workers in the economy are employed - don't pay too much attention to whether the aforesaid policies are sustainable because "in the long run we are all dead."
Keynes didn't advocate nonstop deficits, however, and he even suggested (whether he meant it or not) that a government should run surpluses during economic booms so as to balance its budget over the cycle. Ibid.
Although one might wish the US economy was growing more rapidly, it has been expanding since 2010. The unemployment rate has fallen from over 10% to 4.1%, which is about low as can be expected. Even based on the tenets of Keynesian economics, this is hardly a time for ramping up the government's deficits willy-nilly.
C. Downside risk - The previously cited article by Connor Sen acknowledges that the high deficits "experiment" that is underway could backfire, leading to faster inflation instead of robust productivity growth. Trump's economic gamble might actually make sense, op. cit.
The deficit experiment has two possible outcomes. In the best case, the U.S. gets some form of productivity miracle. In the other, rising inflation forces the Fed to raise interest rates to cool off the economy, triggering a recession.
Without discussing the odds for the best-case outcome versus the other, Mr. Sen goes on to downplay the possibility that inflation might get out of hand. Ibid.
Most policymakers, economists, and investors aren't worried about a period of inflation like what the world experienced in the 1970s. In advanced economies, central banks have the tools they need to fight it. Slow productivity growth, by contrast, has become a real concern, especially as countries seek the resources to take care of aging populations and still invest in their futures.
Really, how can one assess whether a gamble makes sense without considering the odds? Is this an even money bet or a 10:1 long shot?
And while a carefully structured tax cut might represent a risk worth taking, politically motivated changes to the plan could easily alter the conclusion. Tax rate cuts will produce better results than special tax preferences; deficits are too high already (which argues for spending cuts versus spending increases).
Reflecting decisions that have already been made (lax congressional budget process - GOP tax cut in December - Bipartisan Budget Act in February), trillion-dollar budget deficits are on tap for the next several years if not longer. And according to the president's budget proposal for FY 2019, gross national debt will stand at roundly $30 trillion (versus $20.9 trillion currently) by 9/30/28. Let's make the budget process work, 2/19/18.
Strong fiscal stimulus during an economic upturn is inherently inflationary. Inflation in turn leads to higher interest rates. And steadily rising federal debt will contribute to concerns about the safety of US Treasury issues. The next financial crisis, Peter Morici, Washington Times, 3/1/18.
America prints the world's money - foreign central banks hold Treasuries to back up their currencies, because most international transactions go through the dollar. However, bond markets no longer assign a premium to U.S. government bonds as compared to the securities of other low risk sovereigns like Germany - that indicates international creditors are getting less confident about the U.S. dollar and debt.
Rising deficits & federal debt - higher borrowing rates - substantially increased interest expense - reduced fiscal running room. Ibid.
As deficits keep soaring, we can expect investors to demand higher and higher interest rates on Treasuries. During the next recession that could well force huge tax increases or draconian budget cuts and send the economy into a death spiral. All that would spin defaults in mortgage and corporate debt, and loan defaults would deal a body blow to major banks.
Haven't Connor Sen and other observers assured us that the Federal Reserve has the understanding and tools to prevent something drastic like that? Sure, but history has shown that (1) financial crises are difficult to foresee before the fact (just about everyone was blindsided by the global financial crisis of 2008-2009), and (2) central bankers et al. tend to be overconfident about their ability to cope. This Time is Different: Eight Centuries of Financial Folly, Carmen Reinhart & Kenneth Rogoff, 2009.
The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times: crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. Unfortunately, a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off.
So far the US inflation rate has remained rather tame, and the consensus is that it will settle at around the Federal Reserve's 2% target rate. This conclusion isn't based on the economic fundamentals, however, so much as on prevalent expectations - which could change quickly for no apparent reason. Why an unpleasant inflation surprise could be coming, Greg Ip, Wall Street Journal, 2/28/18.
A case in point: in 1966, inflation, which had run below 2% for nearly a decade, suddenly accelerated to over 3%. Some of the circumstances echo the present: unemployment had slid to 4%, taxes had been cut and federal spending for the Vietnam War and Lyndon Johnson's "Great Society" programs was surging. Deutsche Bank economists note the budget deficit jumped by more than 2% of gross domestic product between 1965 and 1968, similar to what they project between 2016 and 2019.
If inflation speeded up, the Federal Reserves could throw on the monetary brakes - but this would probably result in a recession and set back the quest for faster economic growth by quite a bit. And if the Fed procrastinated, the results could be even worse.
Thus, by Mr. Ip's account of what happened after inflation spiked in 1966, the Federal Reserve bowed to presidential pressure (first from Johnson and then from Nixon) to maintain easy money policies. Both inflation and interest rates rose to double digits by 1981. Ibid. [At that point, incoming Fed Chair Paul Volcker took decisive action to end the inflationary spiral and restore order.]
D. Political considerations - We suggested earlier that politicians "instinctively yearn to . . . spend money on their favorite government programs without the need to raise taxes." Here's some supporting evidence.
#PRESERVING STATUS QUO - Only a few weeks after the GOP tax cut, politicians on both sides of the aisle supported the Bipartisan Budget Act, which paved the way for some $400B in spending increases for FY 2018-19. More shutdown drama, mediocre results, Section C, 2/12/18.
This was basically an across-the-board spending blowout; very little attention was paid to the possibility of economizing in some areas to offset increased spending in others. The next financial crisis, Peter Morici, op. cit.
The recent budget crisis required $300 billion in new spending [exclusive of $85B for disaster relief, $30B for CHIP, and $20B for infrastructure] to get enough Republicans and Democrats to sign on, because neither side was willing to even talk about cutting out the fat in programs that serve their cherished goals - income redistribution for the Democrats and tougher border controls and a stronger military for the Republicans.
Here are some examples of spending cut ideas that aren't universally popular: Faithfully enforce Social Security disability rules - impose work requirements for welfare programs - reconsider 20-year retirement for military personnel - downsize or eliminate programs and departments that have outlived their usefulness (GOP senators "went apoplectic" when Secretary Rex Tillerson said he could effectively run the State Department with many fewer people) - terminate the Appalachian Regional Commission, 18 other regional commissions, and Community Development Block Grants. Ibid.
Realistically, none of these ideas could come to fruition without abolishing the Senate filibuster rule (which creates a supermajority requirement for spending cuts), and possibly making other changes in the way Congress is run. Ibid.
It's virtually impossible to address those issues with the 60-vote rule in the Senate, House rules permitting the speaker to require bills be backed by a majority of his party before reaching the floor, and both houses having significant caucuses of rigid and uncompromising liberals and conservatives.
#NEW INITIATIVES - Even if our political leaders aren't willing to cut existing government programs, one might expect them to think twice before proposing new ones. In practice, however, new programs keep being proposed from both sides of the aisle. Here's an example to make the point.
Spending for entitlement programs, e.g., Social Security & Medicare, has far outstripped initial estimates and now constitutes over half of the federal budget. There has been corresponding shrinkage in the funds available for traditional government functions (e.g., defense), which goes a long way towards explaining the growing reliance on budget deficits to "make ends meet."
It's often said the fiscal problem cannot be solved without restructuring entitlement programs in some fashion. Paul Ryan says he's still a deficit hawk, Joseph Lawler, Washington Examiner, 2/13/18.
"Over the long-term horizon, we've got to get this debt under control and the only way to do that is entitlement reform," Ryan said in an interview [by Maria Bartiromo] on Fox Business. "That's why we're never going to give up on entitlement reform."
One might think our political leaders would be focused on responding to this challenge, but there has been a lot more talk than action. And some members of Speaker Ryan's party seem more interested in selling yet another entitlement program.
Paid family leave is said to be a pet project of first daughter (and White House adviser) Ivanka Trump, and it was included in the president's first budget proposal with a claim that the relatively modest cost could be fully offset by "package of sensible reforms" to the Unemployment Income system. (The logic for reinvesting the UI reforms rather than applying them to deficit reduction was not explained.) Pluses and minuses: assessing the president's budget proposal, 6/5/17.
As of yet there has been no congressional action to establish a federal family leave plan (FLP), but this project has picked up two influential supporters. Senators Marco Rubio (R-FL) and Mike Lee (R-UT), who succeeded in getting a bigger increase in the Child Tax Credit than had been contemplated for the Republican tax plan, are now supporting a federal FLP that would be "paid for" by reducing future Social Security benefits for FLP recipients. Ivanka, Rubio find a new project: Paid family leave, Seung Min Kim, politico.com, 2/4/18.
Capitalizing on President Donald Trump's endorsement of the idea in his State of the Union address, Rubio is trying to marshal Republicans behind a plan that would neither impose a mandate on employers nor raise taxes to pay for it - two hurdles that have long halted the GOP from embracing paid family leave.
Realistically, an obligation to repay current FLP benefits decades in the future would be a farcical way to "pay" for them - which would almost certainly not be enforced when the time came. A new GOP entitlement, Wall Street Journal, 2/27/18.
. . . wait until you meet the focus group known as Congressional Democrats, who are already dismissing the proposal as unfair for forcing women to choose between children and retirement. Democrats will quickly wipe out the deferral period so everyone is entitled to leave now and get the same retirement benefits later. And once Republicans open Social Security for family leave, the door will open for other social goals. Why not college tuition?
#"Current policies appear to transcend the rather fuzzy limits of Keynesian economics." Keynes is dead, and his policies have been repudiated by stagflation.
Comment: The point is not that Keynesian economics is valid, indeed the discussion in the blog entry suggests the opposite, but simply that some observers have proposed an even more extreme view of why and when fiscal stimulus may be justifiable.
#"[Tax cuts are expected to] increase deficits by about $1 trillion (net) over the next 10 years." Not much, and I do not believe the CBO or other wonks who generate political numbers.
Comment: Most reputable number crunchers have concluded that the GOP tax cut will increase deficits over the next 10 years by about $1.5T gross/ $1.0T net. This compares to projected deficits of $7.1T (and even larger increases in debt) over this period, and it doesn't reflect the potential economic/tax revenue gains from cutting regulatory "red tape".
#Re "Peter Morici's suggestion of reconsidering 20-year retirement for military personnel, and reduction of administrative bloat at the top." The number of O5 and higher officer count could be reduced except in special areas like Delta or subs. 25-27 year limits would retain more talent at a lower cost.
#Too many Republicans support tax preferences that will benefit their donors and cronies.
#"If [the president] were as zealous about balancing the budget as he has been in harping about trade deficits (offering cures likely to prove worse than the disease), imagine how much brighter the outlook might be." We have NEVER had a balanced budget so that is a mere talking point. The debt has increased every year in the last 4-5 decades.
Comment: The government ran modest surpluses for fiscal years 1998, 1999, 2000, and 2001. Gross debt increased by $405 billion over this period, however, and there has been no actual debt repayment (in nominal dollars, ignoring inflation) since 1951.
#One of my difficulties with the subject - which is grave - is the proposition of knowing what'll happen during the next 10 yrs...
Comment: Financial projections are inherently uncertain. Consider how the projected deficit for FY 2012 evolved: $48B surplus projected in BP 2009 (Bush) --- $581B deficit projected in BP 2010 (Obama) --- $1,087B deficit (actual result). However, there is no apparent reason to view the current projections as unduly pessimistic.
#Are you familiar with the work of David Smick. His 2008 book, "The World is Curved," has been hailed by some as eerily prescient of the financial crisis that was then just about to hit. [Your faithful scribe has ordered this book to check it out.]